Last week, China slid ahead of Japan as the second largest economy in the world behind the US. The economic rise of China has caused a lot of soul-searching in Japan, and some deep misconceptions–along with hand wringing–in the US.

Is China a more innovative, modern, and prosperous society than the US, as some commentators seem to believe? By every measure, certainly not.

Is China in any way an economic threat to the US? Are you kidding?

All we have to do is look at the numbers to see why the Thomas Friedmans and the Cassandras of the world are full of horse manure when it comes to China’s economic “prowess” or “might”.

Many in the US would be surprised to discover that Japan has never been the number one economy in the world–people seem to have had the impression that it had surpassed the US years ago. So, when they hear that China has surpassed Japan, they think that the US will soon fall behind.

The first graph is a comparison of the US, China, and Japan, by Gross Domestic Product (GDP). From this, we can see that China’s GDP is just above Japan’s, and is still about one-third that of the US. Or, to put it another way, the US economy has always been nearly three times larger than the nearest competitor–since World War 2, the US has always had many times the wealth of the rest of the world.

However, this does not tell the whole story, as the US, China, and Japan are not equal in population. Surely, on a per capita basis the US lags far behind? While this may be true of the US when compared to some European and oil soaked nations, it is not at all true when we compare the US to China and Japan. While the per capita GDP relates only indirectly to the average salary one receives, it is still fair to say that in absolute dollar terms, Americans are slightly better off than the Japanese, and more than ten times better off than the Chinese.

Of course, the Chinese get more bang for their buck, so they really aren’t that bad off compared to Americans. While this might sound like a reasonable supposition, it needs to be backed up by facts, and not anecdotes on how well off some Chinese seem. Fortunately, there is a way to measure the relative wealth of a country while adjusting for exchange rates. This is through Purchasing Power Parity (PPP). PPP essentially involves taking a basket of goods and comparing the price you would pay for those goods in one country with the price in another, and then adjusting the exchange rates accordingly. When the per capita GDPs of the US, China, and Japan are adjusted for PPP, the situation still looks fairly grim for the average Chinese person. (Since the PPP of a currency can vary depending upon what basket of goods is used and who is doing the shopping, here I am using figures from the IMF.)

When adjusted for PPP, the per capita GDP of China is still only $7,518. According to the US government, the poverty line in the US is $10,890. While GDP per capital is not exactly the same as actual income, it is clear that by US standards nearly everyone in China still lives below the poverty line, even when we account for the lower prices of goods in China.

In short, China is still very much a developing country. Most people in China live in small apartments or duplexes nearly devoid of furniture or decoration, without air conditioning. If they live south of the Yangtze River, they will not have central heating in their house as well, since it is not required by law. Many people in rural areas or urban slums do not have running water or toilets. While lower-end computers can be bought in China for about $500 if one shops around, the vast majority of Chinese people cannot afford one, which is why Internet cafes are so ubiquitous in China.

Let’s be clear: in China, the very, very rich live in nice apartments or duplexes, have air conditioning and heating, have one car, and have a computer. This is extreme wealth in China. In America, this describes middle class life.

But China is rapidly growing and will soon catch up the US, some might say. While the first part of this sentence is no doubt true, the second part is highly debatable. Let’s deal with the “rapidly growing” part first.

The US economy has grown an average of 3.3% a year since 1947, and is in fact growing at 3.2% so far this year, so there is no reason why the economy should not continue this trend. While in the last few years China has been growing at a blistering pace of over 10%, depending upon who is doing the measuring, the Chinese government itself wants to keep the growth rate at 8% or below to keep the economy from overheating. There are good reasons to suspect that China will not even be able to sustain an 8% growth rate over the long haul, but let’s assume 8% is feasible. For consistency and as a point of comparison, let’s keep Japan on the graph. It now has a zombie economy and will be lucky to sustain more than a 1.1% growth rate without substantial structural changes to the country.

Using a straight line projection (i.e., one that assumes the economies will grow at the exact same rate over time), then the Chinese economy will surpass the US economy in about twenty years. If this happens–and I am not holding my breath on this–good for them. China is a poor country. Why should it be stuck with an economy smaller than a country one fourth its size?

However, the real story is the GDP per capita adjusted by PPP. With this, we get a different picture entirely. Here, China will need 25 years to surpass Japan, and the average Chinese person will not see a lifestyle equivalent to the average American for more than 40 years. Indeed, it will take nearly 25 years for most Chinese to enjoy the same kind of lifestyle as most Americans enjoy today–assuming that their economy continues to grow at the present rate, which is a big assumption.

Can China sustain this growth?

In capitalism, over the long-term, growth closely correlates with innovation, having a diversified economy, and risk-taking. Compare the top twenty companies of the US and Japan with that of China, and you will quickly see why Japan is in the dumps and China has a sustainability issue.

To begin with, here are the top 20 companies in the US, according to Fortune Magazine:Three things jump out immediately from this chart. First, America’s economy is highly diversified. Second, most of these companies were started by a single individual with a vision and a new way of doing business–a risk-taker. Third, at least six of these companies were established by inventors or tinkerers. While it is true that AT&T and GE long ago varied from the visions of their founders (Alexander Graham Bell and Thomas Edison), and General Motors can no longer be thought of as innovative, their inclusion on this list shows us something about the US economy, past, present, and future. And, while we cannot necessarily expect these companies to continue to lead the expansion of the US economy, there are a host of new companies (Microsoft, Dell, Apple, Cisco, Intel, etc.) rounding out the top 100 US companies which are seeing rapid growth through innovation, and which each have yearly revenues in excess of $35 billion.

We see immediately that Japan’s economy is much less diversified than the US’s. And, though in the past a handful of men like Akio Morita of Sony personified risk-taking and innovation, that generation has now passed on and there are few Japanese rising to the challenge–nearly all of these companies are now known for playing it rather safe. Interestingly, while nearly all of these companies have stressed innovation, none of these companies were established by an inventor or have made invention a serious part of their business plan. Even a company like Sony has always relied heavily on patented technology from the West.

The genius of American business is that it invents new thingamabobs that no one has ever thought of before, in the process creating whole new markets and spurring economic growth. The genius of Japanese business is that it improves upon the thingamabobs created by others, beating them at their own game and taking away market share. However, since the Japanese–unlike the Americans–by and large do not create new markets through invention, the Japanese economy is still highly dependent on economic conditions elsewhere and market trends which are beyond its control. The market for electronic goods such as TVs and radios has declined, and Japanese autos are overpriced because of a high exchange rate. Since Japan has put all of its economic eggs into these two baskets, and since they have not created very many new products that would create for them new markets, their economy is now relatively stagnant.

Nearly all of these companies are in fact State Owned Enterprises (SOEs) that effectively have complete monopolies, or have been designated a set market share by the government. There is not a high-tech, software, or electronics manufacturing company in the bunch–in fact, there is not a single Chinese high-tech, software, or electronics manufacturing company in the Fortune Global 500. While there are two automotive companies on this list, neither could be thought of as even remotely innovative, and even on the domestic car market they are only competitive because of joint ventures with western auto companies. The top 20 companies in China are, all in all, not very competitive or diversified. As far as innovation is concerned, it is non-existent.

Many Americans started hand wringing when Lenovo bought IBM’s PC division, as though this meant the decline of US technology and the rise of China. While it is true that Lenovo is one of the largest PC manufacturers in the world and the largest in China, it is not in the Fortune Global 500, and its revenues of $14.9 billion a year are dwarfed by IBM’s $95.75 billion. What does it mean when someone pays $1.75 billion for a failing manufacturing division of a US company, when they could have spent $100 million to fund R&D and gotten a better return? It means that the managers of Lenovo got took to the cleaners, and the engineers at IBM have one less headache to worry about.

If it could be said that America invents new thingamabobs, and Japan discovers ways of making those thingamabobs better, then we could accurately say that China manufactures thingamabobs for Japanese, American, Korean, and Taiwanese companies. By and large, the Chinese do not invent new products or improve on existing ones. The main selling point of Chinese products is not innovation, but inexpensive costs based upon the advantages of having a partially closed economy and favorable exchange rates. Lacking any kind of innovation, the Chinese economy is in the end entirely subject to market trends and economic conditions elsewhere. In short, China is not in economic competition with American business, but is in competition with Vietnam, Thailand, India, Indonesia, and a whole host of other developing nations for the low-paying factory jobs that American business provides.

In the long run, given the large population, the lack of natural resources, and the aspirations of the Chinese people, such an economy is unsustainable: China must innovate to keep the growth engine going. However, there are strong structural reasons why this can and will not happen anytime soon.

Instead of worrying what will happen after China defeats the USA economically, a more potent worry would be, what will happen when the Chinese economy fails?

The figures in the article were adjusted for PPP. However, PPP relates to the purchasing power of a currency in its own country as used by the people living there to purchase everyday items on the domestic market, and not as the currency is used for foreign exchange. PPP has absolutely nothing to do with international trade, exchange rates, or purchasing power overseas. Thus, adjusting the gross GDP of a country by PPP demonstrates precisely nothing. It does not tell us how powerful the country is in the world financial markets, and does not give any insight into the countries’ relative wealth compared to other countries. The only validity to using PPP is in comparing how the average person in a country lives to the life of an average person in another country. The table you presented gives no indication of that.

You are very much mistaken. From everything that I have read by Friedman, he believes that the Chinese economy and government are the best run in the world. His prescription for America is to become more like China so that America can escape its current economic doldrums. Nothing can be further from the spirit of the article I have written.

Hi John,
I enjoyed your article by the way.
Friedman just recently did a talk in Australia (forthcoming book in Sept). Basically he argues that China’s advantage is that the world is very flat. That if you have a good idea for a device (for example) you can get it designed in Taiwan, find a manufacturer in China and distribute through a Singapore mail order house.

But he says very clearly that its the original idea that makes the whole thing work.

And that the advanced economies is where most of those ideas still happen. Google, Facebook, iPads, Smartphones that work – all these things have come from the USA or one of the other advanced economies. But well, China can do manufacturing and that is about it and has a real struggle to think of real innovation.

I think that is not a bad fit with what you are saying – the section on diversification of the major USA companies is a brilliant point – whereas you can see just how far the big ones in China have to go to get rid of their built in inefficiencies.

So I find myself agreeing with you and also agreeing (largely) with Friedman in this specific talk.

He makes the point too that the USA is kind of feeling “whipped” at the moment, but he says the fundamentals are still strong and Friedman is definitely saying it ain’t over for the USA yet.

Anyway .. enjoyed your article – thanks for taking the time to put it up.

Chart doesn’t make much sense. If Americans spend around 3 trillion £ on iraq war, how come they are still on top? I see only one reason for this, they just print out dollars and obligations. Where they get more money from? Oil pipes.

One problem with using (various) PPP data is that it doesn’t account for the rampant inequality in the USA (& China more so). Liberal or conservative, none can deny that the rewards of increased productivity from the last forty years have gone solely to the wealthy. Are the workers getting lazier while the wealthy get smarter & work harder? No. The system has been perverted for the benefit of the rich. When taking into account that the top 10% of Americans own 74% of the US GDP, suddenly 90% of Americans are living barely above the poverty line.

I agree with this article wholeheartedly. I just spend two weeks in China and traveled extensively (Beijing, Xian, Guilin, Shanghai). While I agree that China *appears* to have some elements of the developed world, there are absolutely huge structural issues. It is widely know that the food, water, and air is unsafe in China (food safely is a much bigger issue that has been commonly reported). There are huge numbers of people who are still living third world lifestyles. But, what I found the most amazing the the unbelievable amount of unused apartment complexes and shopping malls – they are all purchased by the small affluent class of the society as a investment – they have no other place to invest their money. This just has to be seen to be believed. Personally, I do not believe this is sustainable and would not be surprised to see some sort of housing deflation in the future. The Chinese are putting every spare penny into housing – it has never gone down and the don’t think they can lose. Tulips, anyone?

It is better to use the power purchasing parity method to measure a country’s wealth because it accounts several factors such as inflation, and the local price of goods etc. According to the IMF’s estimate, China surpassed America in 2014. Meanwhile, the Chinese economy just surpassed the ten trillion dollar mark.

I still believe that China lacks in cultural influence, but then it has a strong military and growing economy, so its much more likely (to me) for the world to become a bipolar place.